You’ve heard it mentioned everywhere, but what exactly is catalytic capital? Why do we need it, who’s providing it, and how does it relate to blended finance? Stacy Xiao from the Catalytic Capital Consortium (C3) has the answers.
What is Catalytic Capital?
Stacy Xiao: Catalytic capital is a subset of impact investing that addresses capital gaps left by mainstream investors. It’s a form of investment that accepts disproportionate risk and/or less return to ensure positive impact and to enable others to invest who would not do so otherwise.
In practice, that means catalytic capital can reach underserved populations and geographies, de-risk novel investment products and models, and support early-stage efforts, so they can build a meaningful track record or adequate scale. Catalytic capital can support small transaction sizes and/or high transaction costs, fuel resilience and flexibility in the face of shocks and crises and address historical biases in capital allocation.
Why Do We Need It?
SX: Catalytic capital is a critical part of efforts to achieve the UN Sustainable Development Goals, which cannot be met with conventional capital alone. Put another way, continuing to grow impact investing without catalytic capital runs the risk of leaving those who are most vulnerable behind, reinforcing societal inequities, and failing to deflect the current trajectory of catastrophic climate change.
How Is It Actually Used?
SX: Catalytic capital plays three roles: seeding, scaling and sustaining.
In the seeding role, catalytic capital can back impact enterprises and investment managers without the track record to attract mainstream capital. At the enterprise level, that might mean an early-stage venture with a novel business model serving residents in underserved communities. At the fund level, it might include investing in a first-time fund manager led by people of colour or women, or a fund pursuing innovative strategies, like monetising new income streams to drive forest preservation.
Catalytic capital is also critical to help scale funds and enterprises. Even after demonstrating early success, fund managers and social enterprises may still struggle to attract mainstream capital. Their track record might be limited, their size still sub-scale, and/or the markets they play in still relatively underdeveloped. They need catalytic capital to continue to build and grow. Investments may be structured and deployed to de-risk opportunities and mobilise additional investment from mainstream investors, as in many blended finance structures. Or they may take a less direct approach, like MedAccess, a specialist subsidiary of British International Investment (BII), which uses volume guarantees to make essential medicines and health care products more accessible in Africa and Asia.
Lastly, catalytic capital can play a sustaining role for high-impact efforts. It fills a long-term or permanent need for capital that will accept concessional returns or disproportionate risk – because that is the only way to serve hard-to-reach beneficiaries or to operate business models that cannot achieve full commercial viability. For example, consider microfinance institutions serving particularly vulnerable low-income communities in frontier markets. Their business models, though profitable, may generate sub-commercial returns, and they may not be able to improve profitability without compromising key impact objectives. Moreover, foreign investors may face disproportionate currency and macro risks that are likely to persist in the long term, discouraging capital providers that might otherwise be attracted to the sector.
Catalytic capital can help bridge these gaps.
How Does Catalytic Capital Relate to Blended Finance?
SX: Though blending is not the only way catalytic capital is deployed, the two are closely aligned. To quote Convergence (the global blended finance network), blended finance is the “use of catalytic capital from public or philanthropic sources to increase private-sector investment in sustainable development”. The market has grown rapidly, with Convergence’s historical database now including 1,600 investors worldwide that have participated in more than US$170bn in blended finance transactions.
In these deals, catalytic capital is deployed “vertically” within a capital stack and alongside the financing that it seeks to leverage. The structure allows organisations to invest alongside each other while achieving their own objectives, whether that’s financial return, social impact or a combination of both.
Catalytic capital can also be deployed “horizontally”, without blending, meaning that it is invested at an earlier stage than the capital it seeks to mobilise (ie, sequentially). A typical example might be an early-stage investment in a pioneering business model that graduates to attracting more mainstream investment once it has grown.
Is Catalytic Capital Just a Form of Concessionary Finance?
SX: Concessionary return expectations can indeed be a feature of catalytic capital deals, but they are not a necessary or universal feature.
In some cases, concessional returns are required to achieve intended impact. Root Capital, for example, analysed more than 1,200 loans to agribusinesses in remote areas. It found that charging the full risk premium to borrowers would make the loans unaffordable. To achieve the intended impact, it needed to take a concessionary approach.
In other instances, catalytic capital might be structured to take on disproportionate risk rather than concessionary returns. In the US, for example, catalytic capital has fuelled new investment funds focusing on Black and indigenous people and people of colour. The investments often have little to do with concessional returns and everything to do with backing opportunities that are unfamiliar to mainstream capital and are therefore viewed with scepticism, at least initially.
There are two additional distinctions when considering questions of concessionality. First, return expectations are not the same as actual, realised returns. Because of the risk elements at play, catalytic capital returns can sometimes be viewed unfavourably even before the risk is effectively analysed (returns may be higher than they assumed). And second, a singular focus on returns can distract from the key question: how can flexible capital enable impact in sectors, communities and situations that mainstream capital does otherwise not reach?
What Kind of Organisations Can Provide Catalytic Capital?
SX: Oftentimes, catalytic capital is considered the province of philanthropic institutions, which have long structured investments that take on disproportionate risks or accept lower returns to achieve impact. Programme-related investments in the US are a good example.
However, public-sector actors and development finance institutions are also active providers of catalytic capital globally, and governments support catalytic capital efforts domestically. Collaborations and specific entities can be set up to source and deploy catalytic capital. One example is Big Society Capital, which is working to build the impact investing sector in the UK and has had significant success in areas such as the domestic charity bonds market, where more than £440m has now been issued. Private high-net-worth investors and family offices can also play a significant role.
Private institutional investors are at the other end of the spectrum. They may seem the least able of all asset owners to deploy catalytic capital, given regulatory constraints. But there are nonetheless many innovative institutional investment strategies at work. Prudential Financial, for instance, created a catalytic capital portfolio that – unlike its main impact investing portfolio – is excluded from its standard asset-liability matching process and can therefore tolerate higher risk and volatility.
The Catalytic Capital Consortium is working to further expand the size and diversity of the investor universe. Our grantmaking programme is collaborating with eight impact investing networks around the world to help build investor awareness, share successful strategies from seasoned investors and contribute to a strong global community of practice.
In What Other Ways Can Investors Be “Catalytic”?
SX: We’ve seen a wide range of actions to catalyse transactions, impact and other developments in the impact investing sector – some through deploying capital, others as strategies to more generally support innovative funds and enterprises.
- At the transaction level, catalytic activities might include funding up-front transaction costs; leading a fundraising round; lending one’s name where helpful in attracting other investors; helping to design the structure of the deal; helping to assemble or strengthen an investee team; supporting an investee with expertise and networks; and sharing market intelligence or due diligence findings with other investors.
- At the ecosystem level, they might include generating and disseminating market information; developing new financing constructs; establishing deal sourcing platforms; and providing investment readiness support for enterprises.
Last year, C3 began publishing a series of guidance notes to help identify the myriad challenges related to efficient and effective deployment of catalytic capital. Drawn from the experience of seasoned catalytic capital investors, the notes are focused on the seeding, scaling and sustaining roles of catalytic capital.